Looking ahead at the investment markets

As we enter the second quarter of the year, the key factors driving the short to medium-term performance of financial markets will be policy interest rate decisions and yield curves. Interest rates are at emergency levels in Europe, the US and the UK, and accelerating economic growth will ultimately lead to a normalisation of interest rates. The timing of this is, however, less certain, and central bankers will have to tread very carefully. What, for example, in this current climate, is a normalised interest rate? The banking sector continues to be vulnerable and a steep yield curve remains important to assist banks maintain profitability and recapitalise their balance sheets to the levels that may be required once regulatory reform is complete. Additionally, public finances are extremely stretched and higher borrowing costs will create additional stress for heavily indebted nations. This is a particular problem for the US where austerity measures have yet to be fully debated, let alone passed, and a significant portion of its outstanding debt is short dated. The case for limiting rate rises is strong, however, leaving rates too low for too long could over stimulate growth and lead to sharply rising inflation. A balance will have to be found to preserve price stability and maintain growth - this is the daunting challenge that lies ahead for central bankers across developed world economies.

Keeping with monetary policy, the end of QE2 is on the horizon should the Federal Reserve keep to its undertaking to complete its asset purchasing programme at the end of June. A large proportion of this liquidity created sits on the balance sheets of US commercial banks and the Federal Reserve will keep a close eye on their lending activities. The creation of credit, through bank lending, will increase the money supply to the economy and further add to the sustainability of a recovery. This is exactly what Ben Bernanke wants to see, however, if the availability of credit grows too quickly, the Federal Reserve will be forced to increase interest rates. This further illustrates the tightrope policymakers will have to tread as they manage their exit strategy.

Cash markets have priced in rate rises through 2011 across the major Western economies - indeed the European Central Bank (ECB) has now started its tightening phase - however, we doubt market participants will react negatively to the initial stage of tighter monetary conditions as they will be clearly telegraphed. Investors are likely to remain focused on corporate earnings and profitability which are forecast to impress. Current equity valuations are not a cause for concern and, with net inflows into equity mutual funds still negative, this contrarian indicator suggests prices will continue to rise, albeit, at a slower pace than we have seen over the last two years.

Of the numerous risks discussed by commentators, inflation is central to the thoughts of most. Headline inflation has remained stubbornly high in many countries due to escalating food and energy costs, although core inflation rates have risen less dramatically. Inflation is generally caused by 'too much money chasing too few goods'. Excess money creation leads to excess aggregate demand, which in turn drives up the price of goods and services. If we look at conditions in the West, money growth is very slow, wage gains are virtually non-existent and there are no signs of excess demand. Core inflationary pressures are muted. Compare this to the developing world where credit expansion has, until very recently, been encouraged, and wages have been rising steeply. Additionally, currencies are generally undervalued and this, in itself, is inflationary.

In the near term, global bond markets are not currently too concerned about inflation, although there is no doubt the medium-term outlook is uncertain. Elevated energy prices are a concern and strengthening business activity in tandem with low interest rates could increase the urgency for monetary tightening. All roads, it seems, lead back to central bankers!